Achieving any goal in life usually involves starting with a plan. Investing is no different. One of the most important things to understand before you embark on an investment plan is the relationship between risk and return.

Some investors focus only on maximising returns without considering the risk taken to achieve those returns. Others are so concerned about losing money that they seek to avoid risk altogether. Yet the single, most important lesson investors can learn is that risk and return cannot be separated.

Common risk profiles

There are many investments available with different levels of risk to cater for investors of different risk profiles. As the investment timeframe is naturally linked to life stage, risk profiles can be generalised across age groups (that is, the younger you are, the longer investment timeframe you have and the more aggressive you can be). There is no ‘one size fits all' approach to risk profiling among age groups.

There are a number of risk profiles, but for the sake of this article, we have outlined the three main profiles:

Conservative

Conservative investors are generally prepared to accept lower returns with lower levels of risk in order to preserve capital. Conservative portfolios tend to be allocated predominantly to defensive assets, such as cash and fixed interest, with the remainder in growth assets.

For this reason, people in retirement (in the wealth protection phase of their investment journey) may adopt a more conservative attitude to risk. They have less time to ride out the ups and downs of the share market and tend to have less of their portfolios allocated to shares and other high risk asset classes.

Balanced

Balanced investors generally have more of an equal mix of growth and defensive assets, and are comfortable with taking calculated risks to achieve good returns.

Growth

Growth investors are more comfortable with a higher level of risk in order to achieve potentially higher returns. Their prime objective is to accumulate assets over the medium to long-term and capital security is secondary to potential wealth accumulation.

Investors in this category can therefore expect to have around 85 per cent of their portfolio allocated to growth assets, although still diversified across shares, property and alternative assets.

Whichever risk profile you may fit into, the most important consideration when it comes to investing is that your investment plan needs to be tailored to your individual needs and goals.

Source: Macquarie

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The foundations of risk and return – Risk is integral to investing. This can be a frightening thought, but risk shouldn’t necessarily be feared, as without it there is less opportunity for reward. Quite simply, the higher the return you want from your investments over a particular period, the more short-term volatility (or risk) you have to accept in the value of your investments. Granted, if you’re happy to receive the bank deposit rate, you can put all your money in the bank, safe in the knowledge that the account balance will rise a small amount every day. But if you want higher returns, you’ll have to take on more risk and consider other investments, such as shares, fixed income, commodities and property.

Accepting short-term volatility for higher returns

Why do some investments offer higher returns than bank deposits? Each investment has different characteristics and offers varying potential levels of return. For example, a share’s return over a particular period is uncertain as the company’s profits are unpredictable, therefore share owners require a greater return than they would accept from bank deposits. What share investors are implicitly saying is “I want a higher return, but understand that I have to accept volatility in returns over the short term”.

Looking at risk from a longer-term perspective

Risk is the possibility or probability of loss. But if you’re talking about one of those frequent falls in a share price on a particular day, is that really an important loss? Firstly, it’s only a loss if you sell the investment. Secondly, most of the time these ’losses‘ are temporary and prices soon bounce back; this is the usual volatility of the stock market. The reason this is important is that the financial industry has defined an asset’s risk as the extent to which its price fluctuates; in other words, risk is the likelihood of an asset not achieving its long-term expected return over a short period.

Perhaps the risk that you should really care about is the possibility of an asset not achieving its expected return over the long term, rather than over the short term. In the case of equity share, such a situation might arise if the company in question goes out of business. So important risk relates to permanent loss of capital, not day-to-day losses of which the vast majority are temporary.

Instead of thinking of volatility as a risk (and therefore something to be concerned about), think of it as the cost of the longer-term return. And, if you’re able to ignore the fluctuations in the value of your investments from day-to-day and month-to-month, it’s a cost you won’t notice.

Diversification is a fundamental principle of investing

Avoiding permanent loss of capital requires careful analysis of the investment in question. But, if a company does go out of business, you can reduce the impact by having diversified your portfolio across a number of companies and even asset classes. 

For example, a simple multi-asset portfolio could include shares, government bonds, corporate bonds and cash. Given each asset class has its own expected return, they can be combined in different ways to target a particular return. If we assume that bank deposit rates are 0 per cent, the expected return from bonds is 5 per cent, and that from shares is 10 per cent; to aim for a return of 5 per cent, you can either invest the entire portfolio in bonds, or split the portfolio 50/50 between shares and bank deposits (or one of many other possible combinations).

Everyone will have a different attitude to risk and, therefore, the returns they require. By adjusting your combination of investments you can control the level of risk and affect your potential returns. This is known as asset allocation and is essential for effective portfolio management.

Source: Aberdeen-Asset

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Leenane Templeton.

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